accounting standards, the institutionaljwu.simon.rochester.edu/papers/ball robin wu-...

Accounting standards, the institutional environment and issuer incentives:

Effect on timely loss recognition in China

Ray BallL*, Ashok Robinh and Joanna Shuang Wuc ' U~iiversil,r oj Chi<.n,vo

" Roc-lresrer Iturinrw oj Trc./t~it>/og~

' U~li,rrsir,r oj Rr>clirsrer

Received Oc~ober 2000. Accepted March 2OOl

Abstract

Accounting income of Chinese companies reponins under both domestic ASBE accoun~ing standards and International Accounting Standards ("IAS") is shown to lack timely incorporation of economic losses. This is less surprising for ASBE-compliant income. because although ASBE standards are based on IAS, they lack important asymmetric rules. such as lower-of-cost-or-market. and Impairment o f long-term assets. More striking is the absence of timely loss incorporation in financial statements certified by international auditors as IAStompliant. IAS resemble common-law standards and are widely believed to increase financial repofling quality. The timely incorporation of losses has become perhaps the single most imponant feature of income reponing under common law (Basu (1997). Ball, Kothari and Robin (2000)).

We attribute the result to the comparatively low incentive of managers and auditors to recognise economic losses in a timely fashion and. conversely, tocomparatively high political and tax influences on financial reponing practices. Our results imply that financial repofling cannot be improved simply by' pvemments mandating accounting standards that evolved endogenhsly in different economies. The most fruitful area for Chinese accounting reform lies not in simply adopting or imitating international accounting standards. but in reforming dornes~ic institutions such as the legal system. corporate governance and auditor training and independence. 8 City University of Hong Kong:

JEL clossijicarion: 082. FO2. GI5. M41 and 053

Keyvords: China: International Accounting Standards: information asymmetry; timeliness: conservatism; institutional development

' Corrcspo~ldcncc t c ~ Prc;Ycssor Ray Ball. Grduar khtu.>l 01 H I I S ~ ~ S S ~ llnircnity of Ckspo. I I01 &st 5Xth Slrecl. Chicago. IL hOh37. USA. Tel: (773) 813 5941: Fan: (773) X.14 4585: E-mail: ray.h;[email protected]*().edu.

We grr~cl'ully acknou,lcdge the helpiitl conlments of Andrelr' I.eone. Row ~V~IIS. Jerry Zimmermnn and t l l t rcfrrcc. Bell 2nd Wu rcccivsd linanci~~l ;iss~sla~lce iron] !he J4bh11 M. 0li11 Izt~untl;~~icvn.

Ko! Roll. Ashr)k Hohitr ntrd Jootrtttr Slrrtotr~ H'rc /

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1. Introduction

Since China adopted its "open-door" policy and embarked on a path to economic reform more than two decades ago. the world has witnessed a stunning transformation. GDP growth has averaged 8 per cent annually. exports have grown at a 15 per cent annual rate, the State's share of industrial output has shrunk from 78 per cent to 28 per cent, close to HK$30O billion of foreign direct investment has been attracted, and individual and foreign portfolio investment have become considerably more significant in the economy.' China is now an active participant in the increasingly integrated world markets.

Prior to the reforms, China's accounting rules were based on a Soviet-era planning system. Since then, China's regulatory authorities, a s with their counterparts in many countries, have concluded that international transacting would be more advantageous if the accounting standards. used by Chinese companies conformed more closely to international practice. Higher-quality financial statement information also increases its use- fulness in evaluating managers. a significant problem given China's transition from state control to a market economy.

Much progress has been made in reforming China's accounting standards. Most notably, in 1992 the Ministry of Finance promulgated a new set of standards for domestic companies. known as Accounring Standards for Business Enterprises ("ASBE"). The ASBE were based on IAS, adapted to local conditions. with the expectation they would remain closely related over time (referred to as "connected tracks").

Despite these reforms. the quality of China's domestic financial statements was thought to be insufficient for international users. First. while ASBE are based on IAS, they are different in several aspects. They d o not provide for important asymmetries in incorporating gains and losses. most notably in the form of a lower-of-cost-or-market rule for inven- tories. or an impairment standard for long-lived assels. Second, under ASBE, international users receive neither a certification that the financial statements conform to internationally acceptable standards, nor an indication of the extent of the divergence. Third, the

, , financial statements of domestic companies reporting under ASBE are audited by PRC audit firms. the independence of which has been questioned. Staff in many of these firms were previously internal accountants in the companies they are now required to a u d i ~ and in the Chinese context, their relationships with and obligations to former colleagues who are now managers in their client companies are likely to still be in place. In view of these limitations of ASBE-compliant reports. PRC authorities also require domestic companies with foreign shareholders to publish a second set of financial statements that are certified as conforming to IAS. The supplemental statements are generally audited by an international ("Big Five") audit firm and are publi>hed in Hong Kong on the same day that the domestic-standard statements are published in mainland China.

The research question we address is whether in fact the use of IAS and compliance certification by international audit firms produces financial statements that are of higher quality than their domestic equivalents. In assessing the quality of financial statements. we put particular emphasis on the timeliness with which accountin.g income in China

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incorporates economic losses. Basu ( 1997) shows that timely incorporation ofeconolnic losses has increased markedly in the US since the 1970s. and that i t provides essentially a l l of the timeliness of accounting income. Ball, Kothari and Robin (2000) show that timely incorporation of economic losses i s perhaps the single most important feature of financial reporting under common-law acco"nting. They argue that this makes financial statements more useful to lenders and i s an important corporate governance mechanism.

Economic losses arise from reduced present values of expected future cash tlows from an individual asjet or group of assets (for example. a portfolio. business unit. subsidiary company. or strategy). Timeliness implies that. soon after managers know about an economic loss. an asset write-down i s charged against income (and /or a liabil- iiy for future cash costs such as employee termination package costs is charged). The likely alternative to timely incorporation of an economic loss in accounting income i s i t s gradual incorporation over time. for example by waiting for each future period's reduced cash flow to be realised ( i -e . by passively waiting for decreased revenues or increased costs to be realised). Accounting income does not generally anticipate increases in future cash flows, meaning economic gains tend to be incorporated in accounting income in an untimely manner. However. in market-oriented common-law countries. Ball. Kothari and Robin (2000) observe a substantial degree of- what Basu (1997) defines as asymmetric conservatism in accounting income. that is, more timely incorporation of economic losses than gains. The corporate governance implication i s that managers have greater incentive to act quickly to stem losses i f they are incorporated in income in a timely fashion. as single. comparatively large. transitory amounts. This causes pressure on managers from security analysts, makes leverage and dividend restrictions in debt agreements binding more quickly (thus altering managers' investment and financing decisions sooner). and reduces current bonuses.

Ball, Kothari and Robin (2000) argue that i f losses are not reflected in the financial statements in a timely fashion. issuers (managers and auditors) in common-law countries are at increased risk of stockholder litigation. However, issuers outside o f common-law jurisdictionsdo not face the equivalent threat. Further, they argue that a variety , . of incentives to not report large transitory losses are more prevalent outside of common- law countries. Because income-statement conservatism i s such an important attribute of accounting and corporate governance in market-oriented common-law countries, we afford it particular attention in assessing the development of financial reporting in Chi- na's transition to a market economy.

To date. IAS have been developed and promulgated by the London-based Interna- tional Accounting Standards Committee ("IASC").' The IASC has develdped IAS with a view to their achieving the comparatively high level of "transparency" associated with common-law countries such as Canada. the US and the UK. IAS standards generally show a strong influence of both US GAAP and UK standards. I f the properties of actually reported financial-statement information are determined primarily by mandating accounting standards. we would expect to observe two properties of the accounting income reported by Chinese companies. First, income reported under donlestic ASBE

: Henceiorrh. 1.4s will hc {he responsibili~y o f a newly rrc;~lsd In~erna~ional Accoul~ling Slunilrrrds Btmrd lo enwre I~;II its rule nlaking is. and is seen to be. indcpeclden~.

would exhibit some ~ilnely incorporation.ol'economic losses due to ASBE bein? adapled from IAS. Second. for companies reporting income statenients certified by international audit firms as I'ully complying with IAS. the IAS-compliant income would exhibit even greater timeliness in incorporating economic losses. This is because I AS rules provide more asymmetry in incorporating gains and losses, most notably in the form of a lower-of- cost-or-market rule for invenlories (IAS 2) and investments (IAS 25). and an impairnient standard for long-lived assets (IAS 36).;

Ball. Robin and Wu ( 2 0 ) argue that issuer incentives. not mandated accounting standards. primarily determine the quality of financial statements. Under their hypothesis. the effectiveness of imposing quality standards by state regulation alone is highly doubtful. For Chinese companies, the implication is that income reported under both ASBE and IAS does not incorporate economic losses in a timely fashion due to incentives to behave otherwise. Transparent recognition of economic losses occurs endogenously in institutional contexts where the demand for this property is comparatively high. and where competing demands on the income-recognition practices of managers and auditors are comparatively low. This is not the situation in China at this point in its economic reform and development.

Many features of China's institutional environment cause us to predict comparatively low timeliness in incorporating economic losses. in both ASBE and IAS accounting incomes. despite state-mandated standards. We conjecture the demand for transparent publicly disclosed accounting information is reduced by the prevalence of guattxi (connections) networks. as well as by extensive share ownership by the State and by institutional investors. These factors increase the likelihood that information asymmetry is resolved at least in pan by private communication rather than through published financial statements.

Conversely, we propose there are substantial demands other than the transparency of financial statement information. The strong politica1 role the PRC Government plays in the accounting system, and the resulting close link- between tax reporting and financial reporting, creates demands such as ensuring a stable source of tax revenue for the State. and avoiding the reporting of embarrassingly large profits or losses. Stock exchange listing rules require companies to be profitable, providing a further incentive to hide losses.

, ~

Many institutional features cause inherent limitations on the quality of accounting information. Transactions are widespread amongst organisations with historically close relationships under state ownership and with the State remaining the common controlling shareholder. providing enhanced opportunities for income manipulation to hide losses. Off- balance-sheet liabilities of uncertain quantities (e-g. to provide housing. schooling or health care) further reduce the inherent transparency of the financial statements. All of this is coni- pounded by a shortage of qualified accounting professionals and a lack of auditor independence. which likely hinder the application and enforcement of accounting standards. Finally. the rudimenlary leyal frameworkin China and the essential absence of shareholder litigation provide issuers (i.e. managers and auditors) with little incentive to incorporate economic realities. including losses, in published financial statements in a timely fashion. Consideration of the brc~sder insti~utional environment leads us to conclude that managers

-- 1AS 36 p~sl-dales our UIII~IC ~ x r i t d . 11s ;ls)nirnrlric cll'ccl is diluted hy IAS Ib. wliirh ;lllows (C\CII

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and :tuditors issuing lini~ncial statements in China do not generally have an incentive 10

repon in a transparent fashion. I f issuer incentives prinrarily deternline the quality o f fillan- cial statements. we would expect to observe con~paratively low tinleliness in incorporatin: econon~ic losses in both ASBE and IAS accounting incomes of Chinese companies.

We therefore test the hypothesis of Ball, Robin and Wu (2000). thtit issuer incentives. rather than state-mandated accounting standards per se, primarilydeter~nine the properties of the tinancial statement information Hrms actually issue. Following Ball. Kothari and Robin (2000). we deline economic income in the tradition of Hicks ( 1946). and measure firms' economic gains and losses from fiscal-year changes in their market values of equity, adjusted for capital contributions and dividends. We employ the research design of Basu (1997) in order to identify timeliness in incorporating economic losses.

Our sample consists of 1.625 firm-year observations during the period from 1992 to 1998. Two versions of reported accounting income. certified as complying with ASBE and IAS respectively, are available for a subsample of 289 firm-year observations. Essentially all the sample is subsequent to the promulgation of ASBE. Approximately 90 per cent is subsequent to the completion ofthe IASC's Comparability 1 Improvements Project. which tightened IAS substantially during the period from 1989 to 1995.

We find that Chinese accounting income generally lacks conservatism, both under domestic standards and IAS. Even when Chinese firms use IAS that are similar to those used in common-law countries, and-even when an international audit firm certifies the financial statements as complying with t'hose standards. their reported incomes do not exhibit the dominant common-law property of timely loss incorporation. These results are consistent with the hypothesis that the incentive for financial statement issuers. arising from the general institutional environment in which they are issued. primarily determine the properties of the accounting incomes that firms actually report, not the formal accounting standards per se. I f standards alone determined practice. we would expect to see perhaps some loss-timeliness in ASBE-compliant income. and certainly more loss-timeliness in IAS-compliant income.

We provide an explanation of the paradoxical result of Chen. Chen and Su ( 1999). that accounting income in China is comparatively highly correlated with stock returns. our , '. proxy for economic income. We show this result is due entirely to incorporation o f positive economic income. a Chinese inversion o f the Ball. Kothari and Robin (2000) finding that timely incorporation o f economic losses (conservatism) is the dominant property of accounting income in common-law countries such as the US. This result holds for accounting income reported under both domestic ASBE standards and [AS. We also repli- cate the result of Haw et al. ( 1999b) that 1AS-compliant income of Chinese firms is not more timely than domestic-standard income. These results all are consistent with the hypothesis that issuer incentives. rather than formal accounting standards per se. primarily determinethe quality o f tinancial statements .

Our findings have several implications. First. consistent with Ball, Robin and Wu (2000). we argue that i t is incomplete and potentially misleading to infer a country's accounting properties based on its l i ~ r ~ n a l accounting standards without considering other institutional variables that also inlluence reporters' incentives. Based purely on China's tlccounting standards. one would expect to observe high-transparency accounting information. including reported inconlc that reflects economic losses. Howcvcr. China's institutional enviro~~rnrnt suggests the cuntrilry. and this is contir~netl by our e~npirical results.

Another i~nplication from our analysis is that government regulation is not enough to induce high-quality accounting information. Managers and audit firms must face market- based incentives to ensure such i n formation is provided. If there are substantial demands other than transparency in financial reporting. and conversely if there are few consequences for managers failing to disclose information on a timely basis (such as a lower stock price. a higher cost of capital or shareholder litigation), government-regulated accounting standards will have limited effect on the quality of the accounting information companies actually repon.

A related implicatibn of our results concerns the role of China's accounting development in its ongoing economic reforms. Our findings indicate that accounting variables interact closely with other institutional variables. including the developnient of an independent judicial system, reform of the management and governance of state-owned enterprises ("SOEs"), implementation of bankruptcy law. and reform of the financial and tax systems. For the accounting system to function effectively. parallel developments in all these areas are needed. At the same time, advances in these areas wilI not be possible without developments in accounting. TO date. much attention has been directed at the inrernarionol perspective of accounting reform and to "connecting tracks" with international accounting standards. However. it is likely that the greater challenges facing accounting in China today involve the domesric uses of accounting information (for example, in resource allocation. corporate governance. stewardship and performance evaluation), and the development of auditor training and independence.

Section 2 summarises the development of China's stock markets. Section 3 describes China's accounting standards and discusses institutional factors that are likely to affect the properties of accounting information Chinese companies actually repon. Section 4 presents our research design. A description of the sample and summary statistics are provided in Section 5. Results are presented in Section 6. The last section discusses the research design and offers concluding observations.

, . 2. SOEs and the development of China's stock markets

One of China's most visible economic reforms was the establishn~ent of the Shanghai and Shenzhen Stock Exchanges in 1990 and 199 1. respectively. These markets have expe- rienced tremendous growth since then. By the end of 1998, more than 800 companies were listed on the two exchanges. and their market value reached approximately HK$200 billion, almost a quarter of the country's GDP (Tang, 2000). Establishing stock markets was an integral step in the reform of China's SOEs. which essentially include all of Chi- na's listed companies. SOEs tend to be large enterprises. concentrated in heavy industries or banking services. While inefficient. SOEs are considered the backbone of China's economy. They absorb the majority of China's capital investment, and provide employ- ment to well over half of China's urban workers. Their successful transition from being state owned to being privately owned is considered essential to China's progress.

Listing SO€. can have two principal benefits. First, stock market listing is viewed as a precursor to the SOEs raising much-needed capital. both debt and equity. in a more efti- cient fashion. Historically, the majority of SOE capital has been provided by state-owned banks. employing non-commercial criteria and subsidising inefficient and loss-making

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enterprises (for example, by grantins loans known to be immediately non-perforn,ing) Second, I ~ s ~ i n g alters corporate governance. which in China 1s grossly inefficient due t o

the fact that political bureaucracy is the basis of China's business environment. While there is no evidence that this was an explicit aim of the PRC. listing has the advantage 01 exposing managers to closer scrutiny by shareholders as owners, security analysts and other external parties. Listing provides an external indicator (the share price) of managers' success o r failure. and therefore can be used informally in reappointment and compensation decisions. or even in formal price or price-based compensation schemes. In principle, stock market listing i s an important institutional means of increasing the efficiency o f corporate governance.' ,

The likelihood of China achieving the potential benefits of S O E listing was reduced substantially by several compromises made during the implementation process. First, the privatisation (if i t can be called this) was only partial. T o prepare for listing, SOEs were organised into share-issuing companies and shares were sold to institutional and individual investors. However. a controlling share interest was retained by the State.' Second, the institutional and state-owned shares were restricted from trading. meaning only indi- vidually owned shareholdings are now listed. Third. restrictions were placed on foreign individual investing. Initially, shares were issued only todomestic investors ("A-shares"). In 1992, a second class of shares ("B-shares") was established for foreign investors only." Most companies authorised to issue B-shares already issued A-shares, and approximately 10 per cent of l i s~ed companies with A-shares subsequently issued B-shares. B-share- issuing firms are generally larger. Both A-shares and B-shares are currently listed on the domestic (Shanghai o r Shenzhen) exchanges.' While they are identical in terms of voting rights and dividend rights. B-shares generally trade at deep discounts relative to A-shares (Bailey, 1994). One reason for this is the expectation of foreign investors that they d o not effectively own the same after-tax cash-flow streams over the long term as domestic investors."These restrictions encourage foreign and institutional investors to take a short-term perspective and a limited interest in corporate governance. thus insulating management to a considerable degree from informed. expert scrutiny.

SOE listings have thus contributed to making this ownership reform less successful in increasing their efficiency than many had e x p e c ~ e d . ~

' Sre BaumoI( 1965) and Fama (1970).

? Estimated by Thr Economisr (9 September 2000. p. 94) as "perhaps 55% of all shares".

In February 2001. China opened its B-share markets lo domestic investors. This event post-dated our sample period.

Subsequently. tirms liked in Hong Kong (H-shares). New York iN-shares) and Tokyo (T-shares) are also listed on the Shanghai and I or Shcnzhcn exchanges.

' Governmenrs can impuse discriminatory taxation on dividends and capital gains paid to foreigners: and restrictions on expatriation of dividends or capital gains (including currency ~ransactions. taxes and controls). In the extreme. they can totally expropriate foreigners' claims.

* S~eintild ( 199x1. amongst others. argues lhat the ownership of an enterprise is o l little relevance if tht: institution nf ownership itself has not hecn firmly established.

3. China's accounting system

Before economic reform started in 1978. the state sector dominated China's economy. SOEs were effectively production units set to fulfil quotas allotted by the Government, with supplies and sales guaranteed by the State. at state-set prices. A system of fund accounting was imported in the 1950s from the then Soviet Union. primarily to keep track o f the grant and use of srate funds. and for central planning. Since the State was the sole owner, financial reporting for external users was virtually non-existent.

As reform progressed. the Chinese Government selectively introduced Western accounting terminology and practices for certain forms of business, notably for joint ven- tures in 1985 (in response to increasing foreign investment) and for share-issuing companies in 1992.A defining event in China's accounting reform was the 1992 promulgation of Accounring standards fo; ~usiness ~ n t e r ~ r i s e s (ASBE) by the Ministry of Finance. ASBE standards were mandated for all business enterprises. effective on I July, 1993. They changed China's formal accounting standards from the previous Soviet system to a predominately Anglo-Saxon one.''

While post- 1993 Chinese accounting standards resemble IAS. which have common law origins and are similar to US and UK standards, differences exist. Unlike US GAAP or UK standards, which evolved from a regulated common-law market setting, Chinese standards originate exclusively as code law written by the State. The Ministry of Finance is empow- ered to promulgate accounting standards and consequently its objectives of generating stable tax revenues and safeguarding state assets contribute to rigidity in many areas of accounting. In general, Chinese accounting standards adhere strictly to historical cost and emphasise reliability over relevance (Tang. 2000). For example, there is no lower-of-cost-or-market inventory valuation rule. Provision for bad debts is allowed only up to a specified percentage of receivables outstanding.'' Provision for permanent impairment in the values of long-term assets is generally not allowed. Depreciation schedules. such as the minimum percentage of residual values and useful lives for various assets. are also established by the State. While - ,based on IAS, Chinese ASBE retain subslantial code law features.

For companies issuing both A-shares and B-shares, a second set of financial statements based on IAS is required. The IAS statements are published in Hong Kong the same day the Chinese-standard statements are published in mainland China. IAS statements are generally audited by international auditors. whereas the Chinese-standard statements are generally audited by local firms.

In sunrmary. Chinese ASBE largely conform to IAS. which are derived from US and UK standards. For B-share lirms. financial statements must fully comply with IAS. If formal accounting standards constitute the predominant factor determining the properties

"'The ASBE. which consists ofa set of basic slandwds. is w)~iutimrs viewed as China's co~reptual accounting iratnework. By IW. eight additional standards were issued. dealing with related party tmnsac~iuns. cash-flow statements. events wcurrinr after the balance sheet date. deht rr.struc~uring. revenue. investments. cunstr~~tiot, contrxts. changes in accounting policies and accounting estimates. and corrections ol';wcoun~in~ errors.

" The percentage limit is usu;~lly less than 3%. hut ni;ty differ by industry.

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80 H(,r . Boll. Asliok Rohirl t r r l r l Jocirrr~o Shrrttrr!: I441 / A.ricr-Pfrccrc-~filic. Jourr~ol of Accorlrllin~ & Ecorlorr~ics 7 (2000) 71-96

individuals and organisalions. and accounting information does not reflect current fundamentals, rational outsiders can only speculate on those fundamentals, reacting for example to rumours of events affecting the firm. A third alternative is that China's weak protection of investor property rights and latent risk of state expropriation make accounting fundamentals less relevant to individual investors, compared to factors such as political connections. Ei- ther way, demand from ~ndividual investors seems unlikely to encourage Chinese issuers to report in a transparent fashion.

The socialist heritage of state-owned enterprises in China poses several substantial challenges for establishing a transparent accounting system. One challenge arises from the prevalence of essentially related party transactions. Most listed companies in China were carved from state-owned enterprises. and are still state controlled. Common control of transacting parties by the State questions whether the financial statements are based on transactions that are at arms-length." Close ties also often exist between a listed company and its former parent SOE in areas such as supplies. production, sales. technology. and corporate governance. which points to severe related party transaction issues.I5 Related party transactions provide an easy mechanism to smooth reported income, including the hiding of losses. thereby reducing financial statement transparency.

Another accounting challenge arises from the prevalence of obligations that are not documented in formal legal agreements. SOEs are traditionally more than economic production units. They also bear a substantial but legally and politically undetermined degree of social responsibility. primarily to provide cradle-to-grave care for their employees and their family members. including schooling. medical care and housing. Most of these social responsibilities are unwritten. They are currently treated as "off-balance-sheet," thereby reducing the informativeness of the financial information reported for these enterprises.

A related institutional factor contributing to the reduced transparency of accounting in China is the strong role the Government plays in establishing and enforcing accounting standards. Income for financial reporting and tax reporting are closely linked. as in most other code-law countries such as France, Germany and Japan. Properties of income such as timeliness and conservatism are consequently compromised by the interest of the State in collecting taxes. and the interest of firms in paying them. The objective of generating stable - tax revenues means i t is generally not in the State's best interest to incorporate bad news in accounting income at the earliest possible time, which means accounting earnings will be less timely in reflecting reductions in the firms' values. Rational f m s will manage their operating cash flows and accruals to oplimise tax payments, bearing political costs in mind. further compromising the incorporation of economic reality in reported accounting income.

Conversely. an important institutional factor in China is the comparative weakness of private enforcement of accounting standards. In common-law countries, accounting conservatism is enforced to a large degree through shareholder litigation. Given China's rudimentary judicial system. which has a reputation for succumbing to the influence of the politically connected. it is not surprising that few legal cases have been brought against

'' Under the xcounling standard "The People's Republic of China Accounling S~andard for Business Enterprises: Disclosure of Relaled Pany Rclnlionships and Transac~ions". ~ransac~ions belWcen enlilies under common control by the Slaw do not lead lo qualitica~ion as related party Iransec~ions.

' W n e case is described in Ball and WII 12000)

lirlns and the~r auditors by individual shareholders. Consequently. Inanagers and airdltors have n reduced incentive for timely incorporation of economic losses ("bad news") in reported income. Here too. tlie causality can be argued i n the opposite direction weak enforcement of accounting standards is opti~nal in economies with a low demand for accounting transparency, and a correspondingly high demand for accounting Income that meets other objec~ives.'~

A severe shortage of qualified accountin2 professionals also suggests comparatively weak enforcement of accounting standards in Ch~na. Tang (2000) reports that over 50 per cent of China's CPAs are over 60 years old and only 18 per cent hold university degrees. Since most accountants were tra~ned under the Soviet accounting system and have little knowledge of modern business transactions, their willingness to accept and ability to enforce China's new accounting standards are in doubt. A lack of auditor independence also hinders effective enforcement. Most audit firms are state-owned with the auditors being state employees. The accountability of auditors is therefore reduced as the State bears ultimate responsibility for the audits. Severe problems of independence also arise because both the auditing and audited firms are state controlled. Efforts have been made in recent years to sever the ties between the State and audit firms. Even when official ties are'sev- ered. strong unofficial relations can still exit. When combined with the near absence of incentives from stockholder litigation for auditors to enforce even domestic standards effectively, the poor state of auditor independence and training imply low auditor pressure for financial statement transparency.

Can a similar conclusion be reached concerning the incentives of international audit firms cenifying compliance of AB-share companies' financial statements with IAS? The international firms have access to better-trained staff, without state backgrounds and without close historical ties to their clients. so they would appear to be both more independent and more capable of enforcing a high level of financial statement transparency. Neverthe- less, most of their staff are subject to domestic cultural influences, and could well find it difficult to enforce transparency on clients, particularly in incorporating economic losses in their published statements.

In addition, the audit firm always feels the economic pressure of losing an unhappy client's business, a pressure that is magnified when theclient has close relations with other clients. The essential absence of stockholder litigation applies to the international audit firms as well. because even B-share transactions are executed under the rudimentary Chi- nese legal framework. Perhaps international reputation effects are sufficient to induce international audit firms to ensure high transparency in the financial statements of their Chinese clien~s. but against this we note that i t is unclear whether financial statement users in other countries would be aware of or even care about low transparency in China. let alone the identities of the individual audit firms associated with it. Further, the degree

-- Ib DeFond. Wong and L i ( 19%') find that aher Ihr Chinese Governnien~ imposed stric~ auditor s~andards in

1995. here \vas a "llighl from quality'' by Chinese companies. This is consislent w i ~ h our hypo~hesis hat in China there arc suhstan~ial demands on accounting o~her than transparency and. conversely. that managers do no1 face a market demand for high-qualily financial statrmenls. Keeping the instilutional environment o~hrrwise constant. legislaling stricter audit standards no^ only raises the price charged by the auditor: il also ~ n o r l t s managers to an above-optimal level ol'~ra~~sparency. which they restore hy changing to a lower-qualily audi~ firm.

S 2 Her\. Bcrll. A.xIrok K~)hi ir trrrcl Jotrrrr~cr Slrr~orr,g \.VII /

.4rio-f'rrc.1/ic- Jorrr-rrcrl c!/~Ac.c.c)rrrrrirr$ R. Ec.ortrirr~ic-.\. 7 f 20001 71-96

of influence o f the international firms over the decisions of partners in charge o f individual Chinese audits is not obviously great. All things considered. we are not con- vinced that the international audit firms certifying compliance of AB-share companies' financial statements with ]AS have substantially greater incentive to enforce transparency than domestic auditors certifying under domestic Chinese standards.

In summary, many institutional factors in China suggest a comparatively low demand for transparent accounting information, and a correspondingly high demand for accounting income that meets other objectives. Such objectives include optimising income taxation and reducing political costs, for example, by hiding large losses and profits. Weak enforcement of accounting standards is the norm, and seems best viewed as endogenous. While China's domestic ASBE are based on IAS. and while firms with foreign shareholders also issue financial statements certified by international audit firms as complying with IAS. China's institutional environment indicates that financial statements issued under either standard are likely to exhibit low transparency.

4. Research design

Following Ball, Kothari and Robin (2000) and Ball, Robin and Wu (2000). we imple- mented the concept of financial-statement transparency in terms of the timeliness with which accounting income, as it is actually reported in the financial statements, incorporates economic income. We d o s o because timeliness of incorporating economic reality in accounting income reflects timeliness of incorporating economic reality in the financial statements more generally. This is due to two generic properties of accounting. First, accounting income accumulates on the balance sheet in the retained earnings component of the book value of stockholders' equity. s o timely income recognition translates into timely balance sheet revision of book values. Second, changes in the book value of equity are precisely mirrored in changes in the book values of assets and liabilities, s o timely incorporation of economic reality in accounting income also translates into reported amounts for individual assets and liabilities. and stockholders equity, more quickly reflecting economic reality. Hence, the income statement is sensitive to overall financial statement "transparency".

To identify transparency in relation to economic losses, the piecewise-linear research design o f Basu ( 1997) is adopted:

N1, = Po + $,RDiI ++P, R,, + pz RiI*RD, + E" (1)

Here i denotes the individual firm and I denotes the fiscal year. NI is earnings per share scaled by the beginning-of-the-year stock price." R is economic income as measured by the firm's stock return over its fiscal year (adjusted for dividends and capital contributions). net of the mean market return for that year. RD is a dummy variable to separate out economic losses, with the value of one when R is negative. and zero otherwise.

" For fir~ns wilh h o ~ h A-shares and B-shares. the deflslor is a weighed average of A-share and B-share prices. h o h measured in RMR. A more detailed del-~ni~ion is tivcn in the next sec~ion.

In this model. rhe coeiticient J. rneasurts the sensitivity of accountins income to positi\as economic income. an11 13, measures the i r i c . r - c . t ~ i c ~ r i ~ c r l sensiri\!ity o i accountinp income to negative economic inconic. In other words.J1 is a n indicator of'thc existence o i income-statement conservatism. or the degree ol' ;lsymmetry in timely reporting of economic.losses relative to gains. The total sensitivity of accounting income to increases and decreases of market value of' equity is therefbreJ7, and v,+J,), respectively. The overall tilneliness of accounting income. in reflecting both econon~ic gains and losses. is measured by the adjusted R 2 of' the regression.

A n advantage of this research design is that rather than trying to infer properties of accounting income from formal accounting standards, i t allows actually reported accounting income to speak for itiself." This design therefore allows us to test how nianager and auditor incentives arising from various institutional factors interact with mandated accounting standards to determine the properties of accounting income actually reported.

5. Sample selection and summary statistics

Both accounting information and stock-price data are obtained from the Toiwan Eco- r~omic Jourr~al ("TEJ") database for the period of 1992 to 1998. The sample includes only firms that are listed on domestic exchanges. in other words those with A-shares or both A- shares and B-shares. since firms with H (Hong Kong-listed), N (New York-listed). or T (Tokyo-listed) shares are subject to regulation i n foreign jurisdictions that is likely to be different from that in mainland China."

Holding-period stock returns are calculated for both A-shares and B-shares (RawR" and RawRB) over the fiscal year. with adjustment for stock splits and stock dividends. Since all Chinese companies have calendar fiscal years. returns are measured over one- year periods ending on 31 December. To control the possible effects of changes in expected returns. we subtract the mean return of all A- (B-) share stocks in fiscal year r from firm i's A- (B-) share return to arrive at RA (RE). To measure the change of a firm's economic income over a fiscal year, we calculate Rw. a weighted average of RA and RB, with the weight on RA being the A-share market value at the beginning of the year divided by the company's total market value. and the weight on RB being the B-share market value

'ai the beginning of the year divided by the company's total market value.= A dummy

" Ball. Ko~hari and Robin (2000) identify a variely of reasons why accounting standards do ncn determine the properties of linancial staternenl informalion. We add another reason: slate imposition of standards developed elsewhere on an economy w i ~ h o u ~ an endogenous demand for lhose standards is unlikely lo succeed.

" In 1998. 26 companies had B-shares as their sole class of shares. Thew companies are excluded from our analysis as our ftrus is to compare IAS and Chinese standard slalemenls. and the la~ter are unavailable for these companies.

We measure A-share market value as the A-share price rnul~iplied by the number n f all ou~s~andinp don~estic shares. including those held by Ihe State. instirutions and the public. B-share market value i s the B- share price mul~iplied by the number of shares held by fttreign investors. The co~npany's tcnal market veltle is thr. sum of A-share and B-share market values. Sincc state and institution shares arc not traded. wc alsrt urr a second definition ol' A-share market value Ihat count\ only domestic public shares. K i s~~ l t s arc si~nilur under this delinitictn.

Tabl

e I

r;

P

Sum

mar

y St

atis

tics

Pane

l A:

Stoc

k R

etur

ns

? $ ' P ". 5 2

, '5

-5

.93

-15.

73

3 2

-10.

72

-16.

69

7

.- s

b

-15.

47

-19.

41

- h -

S a

19

96

256

103.

55

79.3

3 1 1

4.51

b

+

2 P F

a

3

1998

53

0 .

11.3

2 - -. 3

3

- a

> ? $

2

:

5 -2

2.

2

C

- s

2

u d

Krr , Rrrll. ~ s l r r , ~ Rohin rrr~rl Jocrn~~r-I Sltrrcz~t,q \ C i c /

A.sirr- Prtcttic Jotrr11~11 r ~ f A C . ~ . O I I ) I I I I I . ~ & E C ~ I I ~ ~ I I ) I ; C . V 7 12(M)Oj 7 1-96

86 Roy Birll. A.rhok Robirr ~ n c l Joonr~o Slrrror~g W L ~ /

Asia-Pocqic Jourtlctl r,jAccorrrrring & Ecorron~ics 7 (2000) 71-96

variable RDWequals one i f RW is less than zero, and zero otherwise. For companies issuing only A-shares. RW is the same as RA

Accounting income is taken from the consolidated financial statements. According to Chinese accounting standards. extraord~nary items are not presented separately as they are under IAS. To be consistent in our earnings definitions. we therefore use bottom-line earnings (including extraordinary items) for both Chinese standards and IAS accounting earnings. The earnings variable NI is defined as Nl,, = (X,,M ,,-, )/P ,,-,, where X is net income after extraordinary items, and N is the beginning-of-the-year total number of shares issued by the company. including state shares. institution shares, domestic public shares, and foreign (when applicable) shares. The price deflator, P, is the beginning-of-year A- share price (if the firm issues only A-shares), or a weighted average of A-share and B- share prices (both in RMB), with the weights determined by the proportions of A-shares and B-shares issued by the company.?' We use NIPRC and NIIAS to indicate Chinese standards and IAS accounting earnings. respectively.

The full sample includes all 1,625 firm-years with A-share returns and Chinese-standard accounting income. f i e AB-share subsample includes all 289 firm-years with both A- share and B-share returns and with both Chinese standard and IAS accounting incomes available. An AB-share subsample of 200 firm-years has stock returns available for a year running from April to April." Table 1 contains sample statistics for the full sample and the AB-share sample. For each variable. the number of observations. mean, median and standard deviation are presented for each year and for all years combined.

Panel A of Table I reports summary statistics for stock returns. In the full sample of 1,625 observations, the mean (median) A-share return is 27.28 per cent (8.1 I per cent), with the comparatively high volatility (standard deviation of 72.7 per cent) characteristic of emerging markets. Returns on A-shares (not held by foreigners) on average are lower for the AB- share sample of 289 observations (mean of 17.39 per cent and median of -0.26 per cent) than for the full sample (27.28 per cent and 8.1 1 per cent, respectively). This is consistent with a size effect since AB-share firms are generally larger than those issuing only A-shares, as well as with firms issuing B-shares to foreigners which have performed worse than the average. B-share returns for the AB-share sample are lower still (mean of 3.7 per cent and median of -10.03 per cent), driven largely by the poor performances of B-share stocks during the 1997- - - 1998 Asian financial crisis.23 Foreign B-shareholders earned substantially lower average returns than A-shareholders in the same firm.

Panel B of Table I reports summary statistics for accounting income. For the full sample. the mean (median) income reported under domestic Chinese standards, NImC, is 2.87 per cent (3.15 per cent) of the beginning-of-period price. The sample of AB-share

?' We measure the number of A-shares as the number of all outstanding domestic shares including those held by the State. institutions and the public. The total number of issued shares of the company is the sum of the A-shares and B-shares. Corresponding to the second definition of A-share market value for the calculation of RW (scr the previous footnote). we also adop a second definition of the total number of A-shares as being only the domestic public shares. Here too. our conclusions arc not substantially affected by using thisdefinition.

?: All Chinese firms are required to disclose their annual financial statements by 30 April. Haw. Qi and Wu (199Y) find that out of the 1.890 earnlngs announcements in thew sample from 1994 to 1997. only five were ma& after the -30 April deadline.

'' Siliiihr results are found for Ihe AB-share sa111~le of 100 observations measured from April to April.

Ray Ball. Ashok Robin and Jonrrno Sh~ro~rg WJrr /

Asia-Pacijic Journal ofAccounring & Econo~nics 7 (2000) 71-96

Table 2 Correlation Coeflicknls

- Panel A: Full Snmpk (1.625 observarions)

-- Nlmc RawRA R A R '" -

NlmC 1.00 0.38'-' 0.43"' 0.43"'

Panel B: AB-share h p l e (289 observations)

Panel C: AB-share D m p k (200 observations)

NInC NIW REV R E P - N F 1.00 0.96- 0.34"' 0.34"'

"' represents signiiicancc at Ihc 1% Icvcl. ' represents signiimnce at the 5% kvel. 'Corresponding io the samplc of 200 observations uwd for thc analysis in Tablc 5. Rcturns arc "raw" and measured ovcr the 12-month period cnded four months after the fiscal ycar cnd. which is 31 Deccmber for all Chinere companies.

Somplc: To remain i n the Full Sampk and the AB-sharc Samplc, a firm I ycar observation needs non-missing valua lor A-share returns and PRC-standard earnings. For AB-share Samplc. non-missing values for B-share returns and IAS earnings arc also required.

Variables: N I is defined as earnings-per-share dcflatcd by thc beginning-of-ycar A-sharc pricc ( i f thc firm issues only A-shares). or a weighted avuagc of A-sharc and B-share prices. with the weights determined by the number of A-shares or B-shares ovcr thc total number o f outstanding sharcs of thc company (if thc company issucs both A and B-sharcs). RawRA and RawRB arc raw retums mcasured over the fiscal ycar for A- shucs and B-shares. respcctivcly. RA is RawRA minus thc mcan return for all A-share stocks for a certain ycar. RB is RawRB minus the mean return for all 8-share stocks for a ccnain ycar. RY is the weighted average of RA and RB. with the weight on RA being thc A-share markct valuc ot the beginn~ng of the year divided by the company's toral market valuc and the wcight on RB being the B-shore market value at the beginning of thc ycar divided by the company's total market vzllue. RETA is the 12-month A-share raw return ended four months after the end of the fiscal year. RETVs thc corresponding return mcasurc for B-shares.

X X Hcr~ Btrll. Asliok Rol>irl clrttl Jotrrrrirr Sl~rtnrrg \VII /

A.vitr-Prrc~fic Jortrr~crl r~ / 'A( .c-orr~i~ irr~ & &t.orrornir.s 7 f-7OiN)) 71-96

Iirms shows similar domestic-standard income on average (mean 2.54 per cent. median 3.01 per cent). However, for precisely !he same AB-share firm sample, income reported under international IAS standards. NI1"s, is approximaiely 30 per cent lower on average than the domestic-standard figures (mean 1.70 per cent, median 2.27 per cent).'J This evidence is consistent with the findings of Chen. Gul and Su ( 1999.). whose interpretation is that income reported under IAS is more conservative than under Chinese standards. We show in subsequent analysis that the difference between the two incomes is an "intercepr effect;" that is, i t is not correlated with economic income and does not reflect asymmetric conservatism in incorporating econon~ic losses. We discuss this distinction further in the concluding section.

Table 2.summarises the Pearson correlation coefficients between the income and return variables for the different samples. The correlations generally are highly significant in statistical terms. For the full sample. we observe correlations of approximately 0.4 between accounting income and returns, suggesting accounting income does reflect information in firms' contempokneous economic incomes.

In the AB-share sample of 289 observations. Chinese-standard earnings and 1AS earnings are highly correlated (coefficient of 0.96). In contrast. the correlations between A- share and B-share returns are far from perfect (0.53 for raw returns and 0.35 for market-adjusted returns). implying that domestic and foreign investors react to information differently. RA has a greater weight than RB in the average return RW, due to the greater number of A-shares outstanding and their price premium over B-shares. which explains its higher correlation with RW. The statistics for the related AB-share sample in Panel C are similar, with NIPRC and NIIAS being highly correlated and both being weakly correlated with stock returns.

6. Results

6.1 F~l l l sample analysis

. Table 3 presents regression results for income under Chinese standards for the full sample of 1.625 observations. Panel A results are from model ( I).TheJ, coefficient of 0.042 is significant at the I per cent level, implying that Chinese-standard income incorporates information in contemporaneous value changes. However, no heightened sensitivity to value decreases is found a s 4 is not significantly different from zero. This contrasts strongly with the results of Ball. Kothari and Robin (2000) for common-law countries. Even though Chinese standards are modelled upon IAS. which aspire to common-law levels of transparency. income reported under these standards does not exhibit the common-law characteristic of conservatism. This is consistent with our hypothesis that broader institutional factors are predominant in determining financial statement properties.

The adjusted R' of 18.49 per cent from the regression is high compared with other countries. a seemingly paradoxical result first reported in Chen. Chen and Su (1999). By way of comparison, Ball, Kothari and Robin (2000) report 11.4 per cent for comrnon law countries

Simil:~r results are also found for \he 100-ohserva~ion AB-share sample.

Roy Boll. Ashok Rohiti ntiri Jocrntlcr Shcrotig Wrc /

Asia-Pocijic Jouri~ol of Accolrt~ritig & Ecot~ot~~ics 7 ( 2 M ) ) 71 -96

Table 3 Contemporaneous Association Between Earnings and Stock Returns: Ful l Sample Analysis

P a r ~ e l A : N l ~ ' ~ = P o +J,-RDY +jl, RY'+JJ RC*RDY + c

be - JJ, JJ, A*. RR'

JJ &

N --&-

0.024"' 0.003 0.042"' -0.002 18.49% 1.625 (9.42) (0.71) (11.82) (-0.17)

Panel B:NIr'C =Be + j , R w + e ( R W ) N l r K =Po + P I R* + .C (Rw<O)

pane/ C-NI~K =J, + B a y + J , R D w +PI, RD" Pb+J, R*' +B,, R w PB+jI, R*'* RDw +R,, R*'RDwD"+ r

F-statistic for al l ITB variables: 1.88 p= 0.11

"' represents significance at the 1 % level. '- represents significance at the 5% level.

represents significance at the 105b kvcl. I-statistics are i n parentheses.

Sample: To remain in the Full Sample. a firrn I year o b ~ r v a t i o n needs non-missing values for A-share returns and PRC-Standard earnings.

VariaMes: NI is defined as earnings-per-share deflated by the beginning-of-year A-share price ( i f the firrn issues only A-shares), or a weighted avenge o f A-share and B-share prices. with the weights determined by the numbers o f A'-share or B-shuts over h e total number o f outstanding shares o f the company (if the company issues both A-shares and B - h m ) . RawRA and RawR%re raw returns measured over the fiscal year for A-shares a d B-shares, respectively. RA is RawRA minus the mean return for al l A-share stocks for a cenain year. RB is RawR' minus the mean return for all 8-sham stocks for a cenain year. R" is the weighted average o f RA and R\ with the weight on RA. being the A-share market value at the beginning of the year divided by the company's total market valuc and the weight on RB k i n g the B-share market value at the beginning o f the ycar divided by the company's total market valuc. RDw=I if R w 4 and =Ootherwiw. PB=l i f the company issues borh A and B-shares, and =O if the company issues only A-shares.

Analysis: Statistics arc from regressions using the pooled cross-section and time xr ies o f l i rm I ycar 0bSe~at ion~.

on average and only 5.2 per cent for code law countries, and Ball. Robin and W u (2000) repon 4.5 percent for a sample o f four Asian count r ie~. '~ One would expect greater transparency i n accounting i n the more developed countries. particularly in market-oriented common law countries. This seeming paradox is resolved by the results reported i n Panel B, where positive and negative return samples are analysed separately.This split shows that the comparatively high income-returns R2 i n China is driven entirely by the positive-return sample (27.32 per cent). When our proxy for economic income is negative (Rw<O), R2 is substantially lower at 1.87 per cent. The pattern i n China is reversed relative to what Ball, Kothari and Robin (2000) repon for the i r common-law category, where the positive and negative sample R2s are 0.4 per cent and 12.2 per cent respectively. More timely incorpora- t ion o f posirive economic income is an inversion o f the income statement conservatism that is now the dominant property o f accounting income i n common-law countries such as the US. I t is consistent wi th the hypothesis that issuer incentives, rather than formal accounting standards per se, primari ly determine financial-statement properties i n China.

Of the 1,625 firm-year observations, 289 correspond to firms issuing both A-shares and B-shares. The availability o f another set o f financial statements based directly on I A S and the monitoring provided by international auditors presumably could cause these firms' domestic Chinese-standard statements to conform more closely to the common law model. To test this, Panel C ofTable 3 includes a dummy intercept and slope variable PB, equal to one if the firm also issues B-shares. and zero otherwise. The inclusion o f DAB adds very l i t t le to the model. The F-statistic for a l l the DAB variables has a significance level o f I 1 per cent, and even this l ow level o f significance comes from the interaction between PB and Rw. The positive coefficient on p,, (0.02, significant at I0 per cent) suggests that if anything, B-share issuing firms are more sensitive to positive returns than other firms, and the insignificant P,, indicates that the incremental sensitivity t o negative returns is indistinguishable from other firms. The results imply that the presence o f international auditors does not add substantially t o the t imely incorporation o f economic losses. which is not entirely surprising considering these auditors function within China's institutional entironment.

6.2 AB-shore sample analysis

* 5

Table 4 presents the results for companies w i th both A-shares and B-shares, which report t w o sets o f financial statements. If accounting standards per se are important i n determining the accounting incomes reported by firms. we would expect NI'AS, which i s certified b y international audit f irms as complying wi th international I A S standards. to be more t imely and conservative than NImC. Panel A reveals that NIIAS and NIPRC are i n fact similar i n terms o f both measures o f transparency. They have similar adjusted R2s (9.49 per cent and 9.19 per cent for NIPRC and NIIAS, respectively). consistent w i th Haw et al. (1999b). Neither shows evidence o f conservatism V3, is insignificant for both), and they exhibit similar sensitivity to positive returns (P, o f 0.046 and 0.051 for NImC and NI1"*. respectively). The smaller intercept for NI1.+' suggests that the lower mean and median found i n Table I for N1l"S are primari ly an intercept effect that do not correspond t o more

-- : W e caulirjn tho~ ~ h e w studies cover o dil'fercnl s;l~l~ple prtritd ( 1985-1995) lhsn ~ h e China sample. atid

l h : ~ counlries represenled in Ihe three calegories are nei1hr.r hot~iogeneous nor exhauslive ol'lheir colegory. Ne\~er~heless. we find the comparison useful. a l k i l i~l~pcrl'ecl.

Roy Ball. Asllok Rohitr nnd Jorrntm Shua~rg WLI /

Asirr- PociJc Jourtlc~l ~J'Acc'o~crt~itrg & Econontics 7 (2000) 7 1-96

Table 4 Contemporaneous Association Between Earnings and Stock Returns: Analysis for AB-share Sample

Pnnt.1 A . N / =Q, +Jl,.RDY +J, R" +Q, R**RDn + E ----

-- 4, b, P, Adj. RR' N J J -----

NI"' 0.027"- 0 001 0.046"' 0.004 9.49% 289 (3.24) (0.10) (3.39) (0.14)

Panel B:N/ =Po + J , R* + e (RW2O) N I = b, +J, R*' + E (RW<O)

Po P , Adj- RJ N Po P I ~ d j . RR' N - NImC 0.027." 0.046"' 10.12% 108 0.028"' 0.050" 2.0240 181

(3.46) (3.61) (3.36) (2.17)

F-slatistic for all B-share variables: 0.62 N . 6 I

F-statistic for al l B-share variables: 0.32 , , H . 8 I

'-' represents signifkance at the 1% level. " represents significance at he 5% level.

represene significance at the 105% kvcl. I-statistics arc i n paren~heses.

Sample: To remain i n the AB-share Sample, a f irm I year observation nnds non-missing values for A-share returns. PRC-standard earnings. B-share return. and IAS earnings.

VnrinMes: N I is defined as earnings per share deflated by a weighted average ofA-sham and B-share prices. with !he weights determined by the numbers o f A-shares or 8-sham o v a the total number o f ouwarding shares of the company. RawR* and RawRn are n w returns measured over the fiscal year for A-shares and B-shares. respectively. R' is RawR' minus the mean rcturn for all A-share stocks for a cemin year. Ra is RawRB ininus the mean m u m for all B-\hare stocks for a certain year. RZ is the weighted average ol' R* and Re. with the weight on RA being Ihe A- share market value at the beginning ol'the year divided by Ihc company's total market value and the weight on Rn being the B-share market value at the beginning of the year divided by the company's taal market value. RDY=I il' R W and =O otherwise. R W = I if RA<O and =O otherwise. RDB= I il' Ra<O a d =O otherwise.

Ann1ys1.v: St;~tistics ;trc iron) regressions using the pooled cross-section and time wries o f t irt l i I year i>hszrvations.

9 2 KO!. Boll. Aslrok Rohirr trtrd Jotrr,~~cr .Slrrrotr# 14'11 /

~.$ier-Pcrc.i/i(./c~rr~rrtr/ r!/'Ac~c.orrrrrir~, & E(.ortorrrrc~.v 7 (2000) 71-96

timely incorporarion of economic losses. Panel 6 reports regressions for separate positive return (RW20) and negative return

(R"'<O) subsamples. Consistenr with Panel A. NI1""hns lower intercepts in both cases. which implies lower reponed income on average and hence "balance sheet" conservatism. However. because reporring lower income under IAS is not correlated with current-year stock returns. IAS inconie is not more conservative than Chinese-standard income. in rhe Basu (1997) sense of asymmetric incorporation of economic losses and gains.

In Panel C , we replace the weighted return Rw with its components R' and RB indi- vidually. and find t h a ~ N1 is not highly related with B-share returns for either set of accounting standards. This implies there is no incremental explanatory power of B-share returns. given A-share returns. It is consistent with A-shares more closely reflecring Chi- nese firms' fundamentals. perhaps because foreign 6-shareholders view themselves as owning less protected claims to firms' earnings streams than domestic A-shareholders. I t is also inconsistent with the view that domestic shareholders are more likely than foreigners to be speculators. rather than investors valuing stocks on their fundamentals.

In Table 5, we repon a regression with NImC and NIIAs as independent variables, ex- plaining stock returns. Returns are measured over the one-year period ended 30 April in order to capture the effects of earnings announcements. The two rows report regressions with A-share and 0-share returns as the dependent variable, respectively. In both cases. when NImC is included in the regression, NIIAS has no added explanatory power, despite the widespread presumption that financial statements certified by international auditors as complying with IAS are more transparent. and are ~ h u s to be relied upon more by inves-

Table 5 R e g d o n o f Stock Relurns on PRC Standards and I A S Earnings: Analysis for AB-share Sample

RET =j3, + I , NIrUC + b, NIrAs + e

Po 41 JJ, Adj. RR' N

RETA 0.152"' 5.2W- - 1.680 10.86% 200 (2.68) (2.08) (-0.68)

RET" -0.06 1 4.545'- - 1.738 10.919 200 , , (-1.36) (2.27) (-0.89)

... represcnls significance at the 1% level. '- represents significance a1 [he 5 8 level.

represents significance at the I046 level. I-s~a~is~ics arc i n parentheses.

Snrnple: Tc> remain i n the sample. a firni I ycar observa~ion needs non-missing values for A-share returns. B- share rclums. PRC-s~andard eaming~. and IAS earnings. Re~urns are "raw" measured over the 12-monlh period ended lour monrhs after the liscal year end. which is 3 1 December for al l Chinese companies.

Mjrinblts: Nl is defined as earnings per share dellated by a weighled average o f A-share and B-share prices, with [he weigh~s determined by [he numbers n f A-shares or B-shares over the oral number oiourslanding shares o f the company. RET' is IIX I?-nit>nlh A-share raw return ended four months after he end nfrhe fiscal year. R E P is [he co)rrespontJing relorn measure ior B-shares.

.4rtrr!\ris: Sra~isrizs are iron1 regressions using rhc pwled cross-section and rime series o i f i rm I year thservarions.

tors. The same result hold.; I,r both domestic and foreign shares. Overall. the evidence is consistent with the hypothesis that accounting standards per se

do not determine important properties ol' accounring income. and that the incentives of financial sratement issuers arisinp from the broader insritutional environmenr are rhe donii- nanr factor influencing financial sratemenr transparency.

7. Conclusions

This paper invest~pater the timely recognition of economic losses in accounting income as reported by a sample of Chinese firms from 1992 to 1998. This property of reported income is a general measure of financial statement transparency, because i t is linked to the timely incorporat~on of economic losses in book value of equity and thus in the book values of assets and liabilities.

We report the new result that Chinese accounting income generally lacks asymmetric conservatism. in that there appears to be more timely incorporation of economic losses than economic gains. This result holds for financial statements issued under domestic ASBE. as well as for starements ~ssued by B-share firms and certified by international audit firms as fully complying with IAS. I t is consisrent with the hypothesis that the incentives of financial srarement issuers. which arise from the general institutional environment in which they are ~ssued, determine the aspects of accounting income firms actually report. not rhe formal accounting standards per se.

I f accounring standards were as important in determining financial reporting as we suspect is widely believed. this would not have been the case. If standards prevailed. income reported under domestic ASBE would exhibit a more timely incorporation of economic losses because ASBE were adapted from IAS. More significantly, if standards prevailed, income certified by internarional audit firms as fully complying with IAS would exhibit even greater timeliness in incorporating economic losses. because IAS rules provide for greater asymmetry in incorporating gains and losses.26

The apparent absence of asymmetric income statement conservatism, in the sense of Basu ( 1997). is consistent with the Chen. Gul and Su ( 1999) result that IAS-compliant income on average is lower than domestic-standard income. We observe a similar mean

,difference in our sample. Other things being equal, lower than average reported income implies lowerbook values for stockholders' equity and hence "balance sheet conservatism" of the rype associared with Gennan accounting. This does not imply ~ a s u : t ~ ~ e "income sratement conservatism" because it is not correlated with economic losses and therefore does not reflect enhanced timeliness in loss recognition. The implication is that income reported under IAS is lower than under Chinese standards in "good" as well as "bad" years.

A porential criticism of our research design is its use of stock returns as a proxy for the flow of value-relevant information over the fiscal year. This is especially troublesome in the case of a country that under our own hypothesis does not experience timely public disclosure of fundamentals. and in which uninformed investors have a reputation for stock speculation.

"' IAS include a lotycr-01'-ct~si-or-~narlirt rule Tor inventorits I I A S 2 ) and invesitnenis ( IAS 2 5 ) . and an i~np;~irn>cn~ slandilrd for long-li\ed ;Irsel\ 11.9s 36) .

Nevertheless, these factors alone d o not imply the flow of' information into security prices is impeded in China. Under our hypothesis, economic fundamentals are disclosed in a timely fashion to networked individuals and organisations. Consequently, by comparison with common-law high-transparency economies, information is more likely to be impounded into securlty prices though the trading of informed investors. Furthermore, because published information is less timely in reflecting fundamentals, rational outsiders earn a reputation for speculation because they can only speculate on the fundamentals and react to rumours about fundamentals and the trading of informed insiders. We caution against judging the competi- tiveness of the stock market in another economy under the implied assumption its institutions for disseminating information are similar to one's own.

In addition, we note that the use of annual stock returns potentially mitigates shon- term microstructure effects on prices. Similarly. firm's annual stock returns are calculated net of the country mean return for that year ("market index"), which reduces the noise in stock returns arising from exogenous (to accounting income) variation in expected returns, as well as macroeconomic and political influences on the overall market.

A related concern is that stock returns in China might not be directly comparable with returns internationally, because investors (particularly foreign investors) believe their rights to future cash flows are not well protected. Consequently, investors are likely to view stocks as possessing limited growth options, making them more comparable to corporate bonds?' The substantial difference in pricing between A-shares and B-shares is consistent with this concern. Against this, we note that the standard deviations of both annual stock returns and accounting in our China sample are very similar to those of the four East Asian country sample in Ball, Robin and Wu (2000). and are larger than might be expected under bond-like pricing. We also note the evidence in Table 4 Panel C, that there is no asymmetry in the relation between accounting income and A-share returns (which are likely to have more secure claims on growth) and that there is no incremental expianatory power of B-share returns, given A-share returns.

Our findings imply that transparency cannot be induced simply by governments regu- lating accounting standards that evolved in other economies. Rather, transparency occurs endogenously in an institutional context that demands transparent, timely accounting information. This demand determines the income-recognition incentives faced by managers and auditors. We conclude that the success of China's accounting reforms will depend to a

' large degree on parallel developments in myriad other institutional factors. In our view, the most fruitful area for Chinese accounting reform lies not in simply adopting or imitating international accounting standards, but in developing domestic institutions such as the legal system, corporate governance, and auditor training and independence.

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